Academic journal article Contemporary Economic Policy

Interest Rate Corridor, Liquidity Management, and the Overnight Spread

Academic journal article Contemporary Economic Policy

Interest Rate Corridor, Liquidity Management, and the Overnight Spread

Article excerpt

I. INTRODUCTION

The aftermath of the recent global crisis is characterized by expansionary monetary policies of advanced economies, which have led to excessive liquidity in global markets and rapid changes in global risk perception. Beginning from the first half of 2009, monetary easing in advanced economies has led to a surge in capital inflows toward emerging economies including Turkey. An outcome of this development was the potential macroeconomic instabilities faced by emerging countries. A major concern has been that unfettered inflows can lead to problems in these countries such as exchange rate appreciation, excessive credit growth, and/or asset price bubbles. Hence, many emerging markets had to amend their monetary policy frameworks and take macroprudential measures in order to address the financial stability challenges posed by volatile capital flows. (1) This article focuses on the experience of Turkey, where the monetary policy framework has been extensively modified in the aftermath of the global financial crisis.

As of the second half of 2010, the Central Bank of the Republic of Turkey (CBRT) has changed the general framework of the inflation targeting regime and developed new policy instruments to support financial stability as a complementary objective to price stability. The new framework largely aims at containing the effects of capital flows on the domestic economy, especially on credit growth and current account deficit, without prejudice to the price stability objective.

In this respect, the CBRT increasingly emphasized credit growth and exchange rate as key channels in monetary policy transmission and stressed the need to have a separate control on these two variables, which in turn requires the use of multiple instruments. (2) A conventional inflation targeting framework with a single instrument might lead to policy trade-offs when large external shocks dominate. For example, raising the policy rate in order to prevent overheating and excessive credit growth during a capital inflow surge might pull even higher capital inflows, leading to overvaluation in domestic currency and a larger buildup of external imbalances. On the other hand, cutting the policy rate to prevent further capital inflows and currency appreciation might feed into a larger boom and have adverse consequences for inflation.

The new policy mix of the CBRT entailed the joint use of the interest rate corridor between overnight borrowing and lending rates, liquidity policy and required reserves in addition to the policy rate. (3) In this article, we focus on the interest rate corridor and liquidity management, and analyze the effect of these policies on the overnight market rate, which is represented by the Borsa Istanbul (BIST) overnight repo interest rate.

The corridor system is employed by many central banks around the world to set interest rates. (4) It refers to the window between a central bank's overnight borrowing and lending rates, where the borrowing rate acts as the floor and the lending rate acts as the ceiling for the values that overnight market rates can take. In a conventional corridor system, overnight market rate is generally kept close to the policy rate. After the global crisis, however, many central banks including the CBRT have abandoned this practice due to the introduction of unconventional policies. (5)

The CBRT has operated an interest rate corridor since 2002. However, the way the corridor system is operated changed considerably in 2010. Until the second half of 2010, the CBRT pursued an overfunding policy which led to a net liquidity surplus in the system. Hence, between early 2002 and mid-2010, the overnight borrowing rate of the CBRT was the effective policy rate with the BIST overnight rate forming very close to the floor of the corridor. In May 2010, the CBRT introduced a new liquidity instrument, 1-week fixed-rate repo auctions. Since then, the CBRT has provided funding mainly through this instrument. …

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